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There's no Law of Averages!

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

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Just yesterday I wrote a pretty long piece about the effects of inflation, and how much you could reasonably expect to save for retirement …

… it turns out that you need to save a lot (per week) to get a little (to live off per year, in today’s dollars).

If you followed along, you would have realized one thing … I used a very conservative annual expected return on my investments of only 8%.

This got me to thinking … what annual rate of return should we be using? Isn’t the historical rate of return from the ‘market’ (hence an broad-based Index Fund) around 12% – 14%?

Let’s face it, the difference between investing $100,000 for 20 years at the 8% and 12% is not the 50% more that you would intuitively expect …

It’s actually a difference of $430,000 or exactly 100% !

That means that whether you make an 8% return or a 12% return is the same as doubling your ‘salary’ in retirement … compounding greatly magnifies success (and, failures!), especially over long periods.

Since the average return for the stock market is 12%, we should use that, right and just double all the numbers that I gave you yesterday [phew!] … right?

Trent from the Simple Dollar asked that exact same question … on June 17, 2007; here’s an excerpt from that post:

Another favorite of mine is the ongoing debate over the Vanguard 500. The Vanguard 500 is an index fund started in 1976 that precisely mirrors the S&P 500, a collection of the stocks of most of the largest companies in the United States. Since its inception, it has averaged a return of over 12% per year. Given that, I often use a 12% annual return as a number to use to calculate annual returns in the stock market over a long term (longer than ten years).

I will never be bold enough to say that I’m absolutely correct and the 12% annual average will hold up, but if you ask me what I thought, I’d say that it will, at least for a while, and I’d dump several reasons on your lap. Someone else would likely disagree with this and deliver several reasons why it won’t happen. I know at least one person with a degree in economics who firmly believes that the next several years will be much betterthan 12% as several new industries come online with marketable products. Who’s right? Only the future can really tell.

How has the market actually fared over the past 10 years?

12%?

No, the broad S&P 500 Index that Trent referred to averaged just somewhere between 2% and 4% over the past 10 years!

The Dow Jones Industrial Index that measures a smaller basket of larger companies averaged just somewhere between 4% and 6% return [AJC: Why the range? There was a major crash exactly 10 years ago, so do we assume we go in at the top or at the bottom?].

Isn’t it great having the benefit of 20/20 hindsight? Does it mean that trent isn’t smart?

No, Trent’s a pretty smart cookie … so am I, and so are you … even smart people get stuff wrong!

For example Warren Buffett (who I like to quote – a lot – on stock market-related topics, because he is regarded as the World’s Greatest Investor) has made some doozies that he openly admits to; here’s just one of them, according to USA Today:

Buffett conceded that he has made what he considers mistakes, including a reluctance to buy large amounts of Wal-Mart stock several years ago. “I cost us about $10 billion,” said Buffett.

I guess for Warren a $10 Billion mistake is the same as a 8% – 10% mistake for us?

Actually no, if you were planning for a 12% return but only got a 4% return, for every $100,000 that you invested for just 10 years, you would ‘lose’ $650,000 – your estimates of future income would be out by a factor of 3 (that’s just like getting a 2/3 pay cut)!

So, here’s what I recommend … as I said yesterday, averages are for everybody – what might happen to everybody anytime.

You are special … you are investing whenever you invest [AJC: stick with me on this!] … and, you have to live forever more with the consequences.

This means that you should plan for the worst case … and smile when the result is better.

So, if you decide that $1,000,000 in 30 years is enough [AJC: I hope, by now, that most of my readers are planning a LOT more a LOT sooner!] and you are willing to take a chance on the averages (i.e. 12% returns), then by all means set aside just $60 a week (starting now) … but, make sure that you index it for inflation (means that you will be saving $85 a week by year 10; $127 a week by year 20; and, $187 a week towards the end).

But, if you want to be certain that you will have $1,000,000 in 30 years, then you had better start by putting aside $110 a week (and, increase to $157 a week by year 10; $232 a week by year 20; and, $343 a week towards the end) … because the market only guarantees an 8% return for every 30 year period in history!

What does this mean?

Aim for the certainty … don’t leave it to chance [a.k.a. historical averages]!

What can you do?

1. Decide whether a different type of investment would be better for you (e.g. direct investments in stocks; or leveraged real-estate; or businesses) in which case you can save the same amount per week and (hopefully) achieve better returns to get you there … i.e. concentrate on investing rather than building income.

2. Increase your income, so that you can just dollar-cost-average into the broad-market Index Fund … i.e. concentrate on actively creating income rather than actively investing the proceeds.

3. Do a little of both.

This blog is aimed at squarely at those who want to do a little of both …

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4 thoughts on “There's no Law of Averages!”

12% is an overestimate of long-term returns for US large cap stocks, 1976 was pretty much the low for the bear market and then the biggest bull market in US history happened from 1982 to 2000. Yes in the last 10 years the return is 4% including dividends for the SPX. I’d use 10% as the best guess of long-term returns but there is no reason that that number would be maintained. Rates of return in the end depend on the risk preferences of investors and they could change in either direction over time….

Looking at the S&P 500 as representative of the ENTIRE market is stupid. Looking at the Wilshire 3000 as representative of the ENTIRE market is stupid. No one who invests in index funds should be investing in ONLY the Vanguard 500 fund. You want a mix of different assets classes: US Large, US Small, Foreign Large, Foreign Small, Emerging Markets, REITs, US Bonds, Foreign Bonds.

When you put together a mix like that (even if you just divide it evenly among all those asset classes), then your results over any 10 year period will be a lot better than just looking at the S&P 500. Check out http://www.ifa.com for some data to show that.

I just want to point out that you should not look at a single index to represent the returns of the entire market.

@ Moom – I’d rather not guess, or take chances when it comes to retirement … that’s why I use 8%: 75 years of S&P 500 history suggest that this is the minimum that you can expect with at least a 30 year outlook.

@ Bob – if you want to get rich, I’d say that ANY of the investment vehicles that you suggest are ‘stupid’ 😉